Why the LLC Requires Time and Effort

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WHY CREATING A
LIMITED LIABILITY COMPANY
TAKES TIME AND EFFORT

by Mary Hanson

In California the limited liability company ("LLC") is much more time-consuming to form than a corporation. It can be much more expensive than an incorporation, even including an incorporation that includes a shareholder agreement among the shareholders of the corporation.

The greater effort and expense is required because of the great flexibility offered by the California LLC. A limited liability company has little structure imposed by California law. In comparison, a corporation has a set structure - shareholders, a Board of Directors, and officers (a President, a Secretary, and a Treasurer, and other officers) defined by law.

The key benefit of flexibility in structuring an LLC is that the participants in an LLC can devise a structure with the type of management they want and the type of tax treatment they want.

This flexibility to "make your own structure" means that the members of a California LLC (LLC's have "members" rather than "shareholders" as the owners of the entity) must put in the time, effort, expense, and negotiation necessary to create the structure.

Avoiding the necessity of crafting a structure and going forward with an abbreviated Operating Agreement may seem to "solve" the problem of spending time and money to create the LLC structure. It doesn't. In fact, it merely serves to establish a fragile foundation for future business and future changes in ownership. As important questions arise over the life of the LLC, the lack of guidance from an adequate Operating Agreement means that the members must negotiate resolutions to issues as they arise. For some issues California law will provide answers if the members' agreement doesn't. Some answers are likely to be undesirable to the members.

The best time to put a structure and method of operation in place is at the beginning when all interested parties are working together to establish the LLC.

Following are a few of the important questions that must be answered in an LLC Operating Agreement in order to provide the structure for the LLC and to provide a basis for resolution of future issues:

· Will the LLC be managed by the members or by managers? This is a key issue, and it must be addressed in the Articles of Organization as well as the Operating Agreement.

Management by Members

If the LLC is managed by the members:

· Will the members decide operational or day-to-day issues by vote?

· How will the members vote? Will voting power be determined as one vote per member, or by capital contribution, or by profit percentage?

· Will there be a higher level of consent for certain actions (such as a sale of assets outside the ordinary course of business, a sale of the business, loans, a merger or consolidation of the LLC, or admission of a new member)?

· How will voting be done? Will meetings be required for voting? Can actions be approved in writing?

· Will there be penalties for a member who violates the limitation on his or her authority?

Management by Managers

If the LLC will be managed by managers:

· Must the managers be members, or may they be non-members?

· Who are the initial managers?

· Can the number of managers be changed by the members? What vote is required to make a change?

· What is the term of the managers?

· How will successor managers be elected?

· Will managers be compensated?

· How will compensation be determined?

· What action will be required to remove a manager?

· If there is more than one manager, how will they make day-to-day decisions?

· What actions will also require consent of the members? Will managers be required to get the consent of members for a sale of assets outside the ordinary course of business, a sale of the business, loans, or admission of a new member?

· If members are entitled to vote on certain actions (by the Operating Agreement or by provisions in California law) what level of vote or approval should be required?

· Will the managers' authority to bind the LLC be limited?

· Will there be penalties for a manager who violates the limitation on his or her authority?

· Will managers be prohibited from self-dealing? What vote of managers or members would be required to approve a transaction in which a manager has an interest?

Member Withdrawal,Termination and Assignment

· How may a member withdraw from the LLC?

· Will a member be permitted to assign an interest in the LLC?

· Will the assignee be entitled to all rights of the original member or only to the distributions to which the member is entitled?

· Will the assigning member continue to have management authority?

· Will other members have a right to approve a member's sale of an LLC interest? Will they have a right of first refusal to purchase the interest themselves?

· Should the LLC be able to terminate or expel a member?

· How will the member's interest be valued and paid on withdrawal or termination?

· Will the LLC or other members be required to buy out the interest of a member who dies?

· Will a member's interest be subject to buyout by the LLC or other members if he or she violates certain terms of the agreement?

· If there is a buyout provision, how will a member's interest be bought out, and at what purchase price?

Financial and Tax Issues

· What will the original capitalization be?

· Will any contribution be made in property rather than cash? If so, how will property be valued?

· Will distributions of income be required? If distributions are anticipated, who will determine when distributions will be made and how much they will be? Will a certain reserve be required, or will a formula be used to determine distributions?

· Will noncash distributions be permitted?

· How will members rendering services to the LLC be compensated?

· How will profits and losses be allocated?

· Will there be special allocations for specific items (such as depreciation)? Will there be special allocations for the sale of assets or other transactions?

· Will additional funds provided by a member be treated as a loan or as an additional contribution to capital?

· Will the LLC have the right to make tax elections without specific member consent? If member consent is required, what level of approval is required?

· Are all members agreeable to the tax treatment of their distributions as earned income (if the members are managers)?

· Do the members wish to have passive income? If this is the desired tax treatment, the LLC should be formed as an LLC to be managed by managers rather than by the members. A managing member's LLC income is earned income.

Dissolution

The structure of the LLC is intended to have a term. An LLC is not intended to have a "perpetual" existence like a corporation.

· What will be the term of the LLC?

· What will the dissolution events be?

· What vote will be required to approve a dissolution?

Approval by Members

· What level of member approval will be required for amendment of the Operating Agreement? If the Articles of Organization and the Operating Agreement are silent on this issue, a California LLC requires unanimous consent.

· What provision will be made for amendment of the Articles of Organization filed with the Secretary of State? If the Articles of Organization and the Operating Agreement are silent on this issue, a California LLC requires unanimous consent. In California, the Articles of Organization cannot under any circumstances be amended by a vote less than a majority in ownership interest.

If an LLC Operating Agreement does not adequately address an issue that arises, here are the three outcomes that are possible:

(1) The members come to an agreement and amend the Operating Agreement if necessary to address the issue;

(2) The members fail to come to any agreement and California law provides an "answer" that prevails in the absence of a contrary agreement of the members; or

(3) The members fail to come to an agreement and California law is silent on the issue. Whatever action is taken by the LLC or its members remains subject to challenge by disgruntled members.